a. Since mortgage lenders have a prior claim on net operating income, with the investor's before-tax cash flow being a residual, increasing the amount of borrowed funds (and thus the debt service obligation) also increases the probability that net operating income will be insufficient to meet the debt service obligation.

b. Since the debt service obligation is a prior claim on cash flow, any variation in operating revenue or expenses will be reflected in variability of cash flows to the equity investors. Since variability is a measure of risk, it follows that greater financial leverage increases the level of risk associated with the leveraged venture.

c. Inept or misguided scheduling of debt service obligations also increases financial risk, which is a phenomenon specific to the financial arrangements surrounding an individual investment decision. The amount of financial risk associated with a particular investment venture is in this sense controlled by the investor.

a. Accurate predictions of loss due to fire, flood, and other natural hazards are virtually impossible for any particular building or property.

b. It is possible, of course, to calculate the odds of such a loss based on statistical sampling techniques. Predictability based on statistical averages is the foundation of the insurance industry. Because their dollar losses are relatively predictable, insurers can develop fee schedules that compensate for all projected losses plus a premium for expenses and profits and a reserve for the unexpected.

c. Fire and extended coverage insurance shifts the risk of property damage by fire, smoke, wind, hail, lightning, flood, etc., from the property owner to an insurance company. 

d. Other types of insurance that property owners frequently obtain include protection against loss or damage to building contents, and coverage on mechanical equipment such as boilers, hot water heaters, and air conditioning units.

a. Business risk is the likelihood that actual operating results will vary from expectations. It stems both from factors internal to the investment equation and from circumstances attributable to the economic environment surrounding a project.

b. Management inefficiencies may cause operating expenses to exceed expectations, for example, or may result in an inordinately high vacancy rate.

c. The economic environment may be less propitious than anticipated, with consequences including an unexpectedly low level of demand for real estate services. This means either a higher-than-expected vacancy rate or reduced rental rates. In either event, an unfortunate by-product will be gross rental revenue below that anticipated at the time an investment commitment was made. This, in turn, means that net operating income will fall below expectations.

a. An unfortunate by-product of this strategy is that opportunities for extraordinary profits are also eliminated. The tendency for expected return to increase or decrease along with associated risk is an inescapable characteristic of free markets.

b. There is, of course, a whole spectrum of risky investment opportunities in the economy. Financial markets allow investors to interact in competitive bidding so that an appropriate level of return is assigned by the market to each opportunity, commensurate with the level of risk perceived by market participants.

c. The significance of all this is that in an efficient market the only way to reduce risk associated with single investment ventures is to choose a venture with a lower expected return.

d. Real estate markets tend to be somewhat less efficient than are organized securities markets. As a consequence, real estate investors who can exploit market inefficiencies are able to reap extraordinary profits without shouldering commensurately greater risk.

a. Diversification does not insure risk reduction unless properties are chosen to avoid high correlation between investment performance of the various assets.

b. Portfolio diversification is a relatively simple proposition for multimillion dollar real estate investment corporations. But most investors face budget constraints which complicate diversification efforts. If it means sacrificing economies of scale by investing in smaller properties, diversification may entail foregoing some expected return.

c. One solution is to pool equity funds with other investors facing the same dilemma. This rather popular approach to the problem is often called syndication. A frequent arrangement involves a promoter who organizes the syndicate and manages the venture for a fee plus a percentage ownership, while passive investors contribute all or most of the equity funds.

a. One of the best methods of reducing that variance risk is to make more accurate assumptions. The more information an investor has about the environment in which investments exist, the more accurate investment assumptions are likely to be.

b. Professional property managers are uniquely positioned to enhance accuracy of cash-flow projections. Capable property managers can greatly reduce the probability of variance between projections and actual outcomes.

a. Tax stops commit tenants to pay all property taxes above some specified level.

b. Escalator clauses require tenants to pay all operating expenses above amounts specified in leases.

c. Net leases, which make tenants responsible for all expenses, shift virtually all operating risks from property owners to tenants. 

d. An additional strategy frequently employed with long-term leases pegs rental rate to changes in a price-level index such as the Consumer Price Index or the Wholesale Price Index.

a. Purchase options are a common form of hedging used in real estate. When contemplating a development project, for example, a developer might purchase an option to buy a selected site. This provides time to plan, to obtain required governmental approvals, and to secure needed financing.

b. Real estate syndicators also frequently hedge by obtaining options to buy properties. Options are exercised only after syndication shares are fully subscribed.

c. Interim or "standby" financing commitments are another hedging mechanism used by investor-developers. To avoid being committed to an unfavorably high interest rate, a developer may purchase a loan commitment that is binding on the lender but is an option to the developer. This commitment will be exercised only if better terms cannot be obtained.

a. Rational investors prefer a higher to a lower return for a given level of risk; for a specified level of return they prefer less risk to more risk.

b. They accept additional risk only if accompanied by additional expected investment rewards.

a. The more risk averse the individual, the more steeply sloped the indifference curve showing that person's preference.

b. The indifference curve of an investor who is indifferent toward risk has no curvature at all.

c. Some investors may even be willing to trade expected return for the opportunity to bear greater risk, and will therefore have a downward-slopping risk-reward indifference curve.

a. carefully specify investment objectives concerning return on investment, timing of return, and acceptable risk levels.

b. identify major risks involved, and quantify them as completely as possible.

c. eliminate some risks, transfer others via insurance or other techniques, and constrain remaining risks to acceptable levels.

d. make a decision to accept or reject the investment, based on whether expected returns justify bearing the remaining risks in view of the contribution the venture makes toward overall investment objectives.

a. This makes interproject comparisons difficult even for the analysts doing the risk estimation.

b. It renders completely impossible the task of communicating risk perception to a second party.

c. This is a particularly serious problem when analysts are working with client investors. Of what avail is the analyst's excellent grasp of the risk element if it cannot be communicated to the client?